MPT is a wonderful theory, but suffers from a fundamental problem. For it to work you need to know the future expected returns, volatilities and correlations for all the asset classes in your portfolio. Unfortunately, no one knows what they are. In addition to being mysterious, they are also ephemeral – they keep changing over time.

Even Harry Markowitz, the father of MPT, knew better than to do this [plan based on those ephemera]. He is reported to have allocated his retirement account at the RAND Corporation 50% to stocks and 50% to bonds, and left it at that. Was he also the father of elegantly simple portfolio theory?

Leonardo da Vinci said, “Simplicity is the ultimate sophistication.” He was right. If you save your clients even 1% annually by building elegantly simple portfolios, you will fund many years of additional retirement for them. They will learn to like simple.

I note the word "ephemeral" in the first quote above. I remember seeing huge differences in Efficient Frontier curves resulting from minor adjustments to the input. It seemed to me the adjustments were close to the uncertainty spread of the data! I think this was from Gibson's book Asset Allocation. He came up with a nice Efficient Frontier graph, changed one little thing and got a quite different graph.

The article also addresses human nature's behavioral weakness to want to keep fine-tuning things. My way of putting it is that if something has lots of knobs and buttons people will play with them -- especially if the "ephemeral" scales on the knobs keep drifting around and newly discovered knobs keep showing up.

Listen very carefully. I shall say this only once. (There! I've said it.)

You would think that the simple 3 fund portfolio (or less) Would be the default for the new investor. But I think that it takes a lot of experience, knowledge and sophistication to convince yourself that this is the best portfolio for most people. Even after all these years, I find myself fighting urges to tinker and change allocations. I fall back on the knowledge I have gained here and all the books i have read.

Even those of us lucky enough to be exposed to and persuaded by the passive indexing philosophy decades ago didn't always adopt the simple 3 or 4 fund approach. Many of us were influenced by "the more diversification, the better" theories of the time (Roger Gibson's classic book in the late 1990s, Asset Allocation, was a major determinant of my original portfolio plan) — and believing in the rewards of multiple asset classes, we invested in as many of them as we could!

If I had it to do over again, I believe the simpler 3-4 fund portfolio would have provided nearly all of the same rewards over the years, with just a tad more volatility — and I would have had fewer funds to manage in my later years. But there's not much to be done about it now, since nearly all of my funds have large embedded capital gains, and would be impractical to sell just for simplification.

I note the word "ephemeral" in the first quote above. I remember seeing huge differences in Efficient Frontier curves resulting from minor adjustments to the input

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Yes, I often refer to the market as a chameleon, ever changing it's color and look.

am:

You would think that the simple 3 fund portfolio (or less) Would be the default for the new investor. But I think that it takes a lot of experience, knowledge and sophistication to convince yourself that this is the best portfolio for most people. Even after all these years, I find myself fighting urges to tinker and change allocations. I fall back on the knowledge I have gained here and all the books i have read.

Yes, Bogleheads' investing is simple, but not intuitive and not all that easy to implement. Lot's of new investors look for the hidden nugget that isn't there. They tend to think that if investing is that easy, I can do a little better if I just add X. They don't realize that using X changes the gift of getting the market return to 4 in 5 odds of not getting the market return.

Thanks for a great article, Taylor. Investors should copy it and tape to their bedroom ceiling.

Paul

When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.

Good article and this is why I believe it is so true. One of my cousins just had a portfolio reivew by Vanguard. They emailed the information to him. It included 4 funds in the AA he would be comfortable at his age.

total stock
total international
total international bond
total international

He even told him he could magage it him self and just purchase the same target fund or lifestyle fund.

So the way I look at it the Vanguard gurus not the CFA, are telling their CFA how people should set up the simple portfolio. Something we already know here.

How simple and how much money investors will be saving if more join in.

bertilak wrote:
The article also addresses human nature's behavioral weakness to want to keep fine-tuning things. My way of putting it is that if something has lots of knobs and buttons people will play with them -- especially if the "ephemeral" scales on the knobs keep drifting around and newly discovered knobs keep showing up.

I love this comment!

am wrote:But I think that it takes a lot of experience, knowledge and sophistication to convince yourself that this is the best portfolio for most people.

I'm pretty short in the "knowledge and sophistication" department but I make up for it by paying very close attention to Taylor.